The specter of bankruptcy is hanging over a major part of South Korea's economy and it could spill over into the banking sector, further threatening the country's stagnant growth.
Shipbuilders are struggling with debt thanks to a deadly combination of a trade slowdown, a glut of vessels and low freight rates hitting the global shipping industry.
The 'Big Three'—Daewoo Shipbuilding & Marine Engineering, Hyundai Heavy Industries and Samsung Heavy Industries—hold $42.1 billion in loans between them, according to local media reports. The firms closed out 2015 with combined losses of more than $6 billion, their earnings reports revealed.
It's a sharp deterioration for the sector, which accounts for 6.5 percent of gross domestic product. Shipbuilders have traditionally been a source of pride for the economy, having played a key role in national industrialization following World War II and accounting for around 200,000 jobs.
"The build-up of debt in Korean shipbuilders is not a Korean-specific problem but an issue regionally as shipbuilders face lower demand. This is symptomatic of weak global trade and Korea is very trade-exposed," explained Trinh Nguyen, senior economist at investment bank Natixis.
In April, South Korea registered its 16th straight month of falling exports.
But debt isn't the only issue plaguing firms.
"Market participants now expect a further decline in capacity utilization in the shipbuilding sector, with the level having already fallen to around 60 percent of the previous peak. Large losses seen by major shipbuilding companies due to the troubles in marine plants are raising further concern about the sector," said Suktae Oh, Korea economist at Societe Generale, in a recent report.
The issue is magnified by the fact that shipbuilders are facing a shrinking pool of liquidity, further increasing the risk of defaults.
How banks are impacted
State-owned lenders have high exposure to shipbuilders so the industry's challenges are now spilling over to their creditors, said Nguyen.
The banks have a mandate to lend to sectors that are important to South Korea's economic development but considered too risky for commercial banks, explained Nguyen. The capital-intensive and trade-oriented nature of shipbuilding often tends to scare private lenders away, he added.
Korea Development Bank (KDB) and Korea Export-Import Bank (KEXIM) have around 60 percent of the banking sector's credit exposure to the shipbuilding sector, noted Oh.
STX Offshore & Shipbuilding—the world's fourth-largest shipbuilder—filed for a court-led restructuring scheme on Friday, local media reported, after its principal creditor KDB, declared that it was no longer feasible to keep pumping money into the shipbuilder. The court will decide whether STX will be restructured or liquidated, according to reports.
Strategists say these banks are in desperate need of additional capital, but the source of funding remains the key question.
Solutions
President Park Geun-hye's administration isn't likely to let the sector collapse but it's also unable to directly help with financing, noted Oh.
"Such a move would require the approval of the National Assembly, and the ruling party failed to secure a majority of seats in the April election."
So, it's up to the central bank to save the day.
Earlier this month, the Bank of Korea (BOK) proposed a bank recapitalization fund that would buy the contingent convertible, or CoCo, bonds of KDB and KEXIM, but the program is still pending final approval.
"The BOK would like to follow the same approach it took in 2009, where the KDB formed a bank recapitalization fund of 20 trillion won (about $20 billion) , which consisted of 10 trillion won from the BOK and 10 trillion won financed from investors and the KDB itself," said Nguyen.
In the meantime, calls are growing for shipbuilders to reorganize and streamline. Hyundai Heavy Industries has already announced it will start accepting voluntary retirements from office workers above the manager level.
But analysts like Oh don't anticipate any big-bang measures.
"Significant capacity reductions and large-scale layoffs could worsen the nation's domestic demand outlook," he warned.
South Korea recorded the worst consumer confidence levels in the world during the first quarter, with 92 percent of individuals feeling the country was in a state of recession, according to a Nielsen survey.
"We suspect that the entire restructuring process will amount to the recapitalization of state-owned banks in the end, perhaps purely for the purpose of avoiding layoffs by providing more credit to shipbuilding companies. So the actual macroeconomic impact of such a restructuring would be minimal," said Oh.